Over the past 20 years OF Crematieverzekering many small businesses have begun to insure their own risks through a product called “Captive Insurance.” Small captives (also referred to as single-parent captives) are insurance companies established by the owners of closely held businesses looking to insure risks that are either too costly or too difficult to insure through the normal insurance marketplace. Brad Barros, an expert within the field of captive insurance, explains how “all captives are treated as corporations and must be managed during a method according to rules established with both the IRS and therefore the appropriate insurance regulator.”
According to Barros, often single parent captives are owned by a trust, partnership or other structure established by the premium payer or his family. When properly designed and administered, a business can make tax-deductible premium payments to their related-party insurance firm . counting on circumstances, underwriting profits, if any, are often paid bent the owners as dividends, and profits from liquidation of the corporate could also be taxed at capital gains.
Premium payers and their captives may garner tax benefits only the captive operates as a true insurance firm . Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral or other benefits not associated with truth business purpose of an insurance firm may face grave regulatory and tax consequences.
Many captive insurance companies are often formed by US businesses in jurisdictions outside of the us . the rationale for this is often that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. As a rule, US businesses can use foreign-based insurance companies goodbye because the jurisdiction meets the insurance regulatory standards required by the interior Revenue Service (IRS).
There are several notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These include Bermuda and St. Lucia. Bermuda, while costlier than other jurisdictions, is home to several of the most important insurance companies within the world. St. Lucia, a more affordable location for smaller captives, is noteworthy for statutes that are both progressive and compliant. St. Lucia is additionally acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.
Common Captive Insurance Abuses; While captives remain highly beneficial to several businesses, some industry professionals have begun to improperly market and misuse these structures for purposes aside from those intended by Congress. The abuses include the following:
- Improper risk shifting and risk distribution, aka “Bogus Risk Pools”
- High deductibles in captive-pooled arrangements; Re insuring captives through private placement variable life assurance schemes
- Improper marketing
- Inappropriate life assurance integration
Meeting the high standards imposed by the IRS and native insurance regulators are often a posh and expensive proposition and will only be through with the help of competent and experienced counsel. The ramifications of failing to be an insurance firm are often devastating and should include the subsequent penalties:
- Loss of all deductions on premiums received by the insurance firm
- Loss of all deductions from the premium payer
- Forced distribution or liquidation of all assets from the insurance firm effectuating additional taxes for capital gains or dividends
- Potential adverse tax treatment as a Controlled Foreign Corporation
- Potential adverse tax treatment as a private Foreign company (PFHC)
- Potential regulatory penalties imposed by the insuring jurisdiction
- Potential penalties and interest imposed by the IRS.
All in all, the tax consequences could also be greater than 100% of the premiums paid to the captive. additionally , attorneys, CPA’s wealth advisors and their clients could also be treated as shelter promoters by the IRS, causing fines as great as $100,000 or more per transaction.
Clearly, establishing a captive insurance firm isn’t something that ought to be taken lightly. it’s critical that companies seeking to determine a captive work with competent attorneys and accountants who have the requisite knowledge and knowledge necessary to avoid the pitfalls related to abusive or poorly designed insurance structures. A general rule of thumb is that a captive insurance product should have a opinion covering the essential elements of the program. it’s well recognized that the opinion should be provided by an independent, regional or national firm .
Risk Shifting and Risk Distribution Abuses; Two key elements of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst an outsized pool of insured’s (risk distribution). After a few years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the essential elements required so as to satisfy risk shifting and distribution requirements.
For those that are self-insured, the utilization of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent doesn’t need to share risks with the other parties. In Ruling 2005-40, the IRS announced that the risks are often shared within an equivalent economic family as long because the separate subsidiary companies ( a minimum of seven are required) are formed for non-tax business reasons, which the separateness of those subsidiaries also features a business reason. Furthermore, “risk distribution” is afforded goodbye as no insured subsidiary has provided quite 15% or but 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to require a current deduction for an estimate of future losses, and in some circumstances shelter the income earned on the investment of the reserves, reduces the income needed to fund future claims from about 25% to just about 50%. In other words, a well-designed captive that meets the wants of 2005-40 can cause a price savings of 25% or more.
While some businesses can meet the wants of 2005-40 within their own pool of related entities, most privately held companies cannot. Therefore, it’s common for captives to get “third party risk” from other insurance companies, often spending 4% to eight per annum on the quantity of coverage necessary to satisfy the IRS requirements.
One of the essential elements of the purchased risk is that there’s an inexpensive likelihood of loss. due to this exposure, some promoters have attempted to bypass the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” during this somewhat common scenario, an attorney or other promoter will have 10 or more of their clients’ captives enter into a collective risk-sharing agreement. Included within the agreement may be a written or unwritten agreement to not make claims on the pool. The clients like this arrangement because they get all of the tax benefits of owning a captive insurance firm without the danger related to insurance. Unfortunately for these businesses, the IRS views these sorts of arrangements as something aside from insurance.
Risk sharing agreements like these are considered without merit and will be avoided in the least costs. They amount to zilch quite a glorified pretax bank account . If it are often shown that a risk pool is bogus, the protective tax status of the captive are often denied and therefore the severe tax ramifications described above are going to be enforced.
It is documented that the IRS looks at arrangements between owners of captives with great suspicion. The gold standard within the industry is to get third party risk from an insurance firm . Anything less opens the door to potentially catastrophic consequences.
Abusively High Deductibles; Some promoters sell captives, then have their captives participate during a large risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the danger pool.
These promoters may advise their clients that since the deductible is so high, there’s no real likelihood of third party claims. the matter with this sort of arrangement is that the deductible is so high that the captive fails to satisfy the standards set forth by the IRS. The captive looks more sort of a sophisticated pre tax savings account: not an insurance firm .
A separate concern is that the clients could also be advised that they will deduct all their premiums paid into the danger pool. within the case where the danger pool has few or no claims (compared to the losses retained by the participating captives employing a high deductible), the premiums allocated to the danger pool are just too high. If claims don’t occur, then premiums should be reduced. during this scenario, if challenged, the IRS will disallow the deduction made by the captive for unnecessary premiums ceded to the danger pool. The IRS can also treat the captive as something aside from an insurance firm because it didn’t meet the standards set forth in 2005-40 and former related rulings.
Private Placement Variable Life Reinsurance Schemes; Over the years promoters have attempted to make captive solutions designed to supply abusive tax free benefits or “exit strategies” from captives. one among the more popular schemes is where a business establishes or works with a captive insurance firm , then remits to a Reinsurance Company that portion of the premium commensurate with the portion of the danger re-insured.
Typically, the Reinsurance Company is wholly-owned by a far off life assurance company. The legal owner of the reinsurance cell may be a foreign property and casualty insurance firm that’s not subject to U.S. income taxation. Practically, ownership of the Reinsurance Company are often traced to the cash value of a life assurance policy a far off life assurance company issued to the principal owner of the Business, or a related party, and which insures the principle owner or a related party.
- The IRS may apply the sham-transaction doctrine.
- The IRS may challenge the utilization of a reinsurance agreement as an improper plan to divert income from a taxable entity to a tax-exempt entity and can reallocate income.
- The life assurance policy issued to the corporate might not qualify as life assurance for U.S. Federal tax purposes because it violates the investor control restrictions.
Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that the owner of a life assurance policy are going to be considered the tax owner of the assets legally owned by the life assurance policy if the policy owner possesses “incidents of ownership” in those assets. Generally, so as for the life assurance company to be considered the owner of the assets during a separate account, control over individual investment decisions must not be within the hands of the policy owner.
The IRS prohibits the policy owner, or a celebration associated with the policy holder, from having any right, either directly or indirectly, to need the insurance firm , or the separate account, to accumulate any particular asset with the funds within the separate account. In effect, the policy owner cannot tell the life assurance company what particular assets to take a position in. And, the IRS has announced that there can’t be any prearranged plan or oral understanding on what specific assets are often invested in by the separate account (commonly mentioned as “indirect investor control”). And, during a continuing series of personal letter rulings, the IRS consistently applies a look-through approach with reference to investments made by separate accounts of life assurance policies to seek out indirect investor control. Recently, the IRS issued published guidelines on when the investor control restriction is violated. This guidance discusses reasonable and unreasonable levels of policy owner participation, thereby establishing safe harbors and impermissible levels of investor control.